Engagement is an integral part of the investment approach adopted by Hermes Credit. By engaging with issuers, we can encourage them to adopt better environmental, social and governance (ESG) practices, and thereby, deliver a better financial return and a public good. Here we explain how we addressed our ESG concerns by engaging with oil producer Pemex.

There is no shortage of evidence that shows a relationship between ESG risk and financial outcomes. Indeed, a plethora of academic and financial studies can attest1. Well-governed companies with minimal or positive impacts on society and the environment tend to have lower costs of capital than their less-sustainable peers.

For credit investors, this has an important implication: companies with poor ESG characteristics tend to have a higher cost of capital because they are exposed to more risks stemming from externalities that undermine corporate financial performance.

By engaging with issuers, we can influence them to adopt better ESG practices, which we discussed in our Q3 issue of Spectrum (See: Petrobas and Pemex: Putting ESG analysis in the oil mix). In doing so, companies can bolster their governance framework and improve the management of their environmental and social responsibilities, such as emission control and labour safety, thereby reducing externalities. Consequently, better societal and environmental outcomes, lower cost of capital for issuers, and enhanced returns for bondholders may follow.

ESG engagement in actionHermes Credit integrates ESG factors into investment decisions, alongside more traditional operating and financial risks. A number of integral inputs help Hermes Credit make the best-informed ESG decisions.

Firm policies, approach, and investment tools are provided by the responsibility team.

At a company-specific level, the team reviews Hermes’ proprietary measure of ESG risk – the QESG scores (with ‘Q’ denoting the quantitative process employed). These QESG scores represent a good snapshot of the overall ESG performance of a company.

The engagement team, Hermes EOS, provides company information. The dialogue Hermes EOS has with a company provides the context of the QESG score. For example, is the company on the right trajectory, or is it more on a negative path?

By collaborating with investment, responsibility and engagement teams, the resulting ESG contribution to investment decisions is more dynamic than, for example, simply relying on scores alone. And, more importantly, because we engage as an investor, companies are more likely to be responsive.

Figure 1: Engagement is an integral part of Hermes Credit’s investment approachSource: Hermes Credit as at January 2018

Hermes EOS usually adopts its proprietary four-step milestone system during the engagement process. Specific milestones can vary by engagement (see Figure 2), but the system allows EOS to track the progress of its engagements relative to the objectives established at the beginning of the process.

Unearthing ESG risks at PemexFounded in 1939, Mexican state-owned petroleum company Petróleos Mexicanos (Pemex), is the eight largest oil producer in the world.

Today, it produces approximately 2m barrels of oil a day and generates $62bn of annual revenue. Although Pemex is wholly-owned by the Mexican state, it relies heavily on international debt markets to fund its operations, with around $87bn of debt outstanding.

Mexico established a wide-ranging set of energy reforms in late 2013, which is having a significant impact. The reforms open up key parts of the energy sector to new players and will gradually increase competition as the government auctions new oil fields, thereby creating new partnership opportunities for Pemex. Furthermore, an oil and gas safety regulator has been established to bring best international practice to Mexico and enforce its application.

In February 2017, Hermes Credit invested in Pemex’s new issue to increase exposure to the energy sector at an attractive relative value for a higher quality investment grade energy credit. An in-depth analysis of the company’s credit profile gave us a better understanding of the company’s oil reserves, production levels and recent operational and financial efficiency initiatives. We also believe we have a firm grip on Mexico’s energy reform programme, the ownership of Pemex, and tax policies.

During our analysis however, ESG factors emerged as recurring themes in the credit discussion.

We wanted to clarify Pemex’s labour safety track record, which was below the industry average, and gain an insight into its environmental management programmes, given the frequency of oil spills and leaks in the past.

For this reason, we characterised Pemex’s ESG risks as higher than average, suggesting that ESG factors could potentially have an adverse impact on the credit. As such, we were reluctant to increase our position in Pemex until we could discuss our ESG concerns with the company, despite relatively attractive bond valuations.

Drilling deep to achieve sustainability targetsTo address our investment concerns, we initiated the engagement process with Pemex. In general, at least two team members accompany Hermes EOS to engagement meetings, especially when the company’s senior management or the chair are in attendance. Notably, we always aim to speak with the board, in particular the chair, as it has been proven the most effective way to conduct successful engagements. And if required, we also engage with the sustainability team and investor relations.

Encouragingly, Pemex was keen to engage. We had previously engaged with the Mexican oil producer, and so, it showed no resistance. It was open to re-engaging and discussing our concerns, indicating that it recognises the importance of managing ESG risks to its debt investors.

Labour safety and environmental management: We were encouraged by the company’s commitment to improve labour safety and environmental management. Pemex assured us that it views a strong sustainability performance, particularly on labour and environmental safety, as essential to gaining access to international debt capital markets in favourable conditions.

Pemex’s performance in labour safety: The International Association of Oil and Gas Producers reported a gap between the average industry performance in labour safety and Pemex. The Mexican company sought to reassure us that its overall performance for the last three years was above average for Europe and South and Central America.Furthermore, the sustainability team highlighted that Pemex’s performance is improving relative to its peers, thanks to a myriad of actions which it is implementing. For example, it referenced a recent campaign aimed at developing a culture of safety and zero tolerance to health and safety risks in the workplace.

Labour safety targets: Pemex published a set of labour safety targets in its 2017-2021 business plan, a move we welcomed. If it achieves its 2021 target, Pemex will equal a reduction of 36% in lost time injury frequency compared with 2015, bringing Pemex's indicator in line with that of its peers.

Mexico’s new regulatory framework: Pemex highlighted that the oil and gas safety agency has tried to bring best international practice - such as adoption and compliance of international technical standards - to the market and enforce its adoption.

Carbon emissions: The commitment by Pemex to reduce carbon emissions by 25% during the execution of the 2017-2021 plan was positively received. Pemex outlined initiatives to reduce flaring, co-generation in various industrial facilities and energy efficiency improvements in refineries. We were satisfied with Pemex's public sustainability targets and the actions underway to achieve them.

Stepping upIf Pemex can demonstrate improvements in labour safety and meet its environmental and sustainability objectives, to our mind, this will reduce ESG risks.

In the meantime, we will continue to engage with Pemex, monitoring its progress against its targets and awaiting an opportunity to reassess our position.